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Jeff Nichols Talks About Gold

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Gold’s recent strength has been fueled principally by a surge in investment buying.  Meanwhile, positive market fundamentals – having to do with trends in mine production, secondary supply, and fabrication demand – have played a supporting role in gold’s recent strong performance.

As important as it is to take a periodic statistical snapshot of gold supply and demand, price developments in the short-to-medium term have less to do with these fundamentals and more to do with market sentiment, monetary policy and inflation trends, geopolitical events, and the resultant changes in investment and speculative demand at the margin.

With gold having bounced around the $900 to $950 per ounce, the metal seems poised to continue its upward march as market sentiment, U.S. monetary policy, rising inflation, become increasingly supportive.

In my view, gold prices are headed much higher with continued volatility around an upward trend.  In fact, there is a high probability gold will break through the psychologically important $1000 per ounce level this year.  Don’t be surprised to see gold trade up to $1,100 or even $1,200 before year-end 2008.

And – with the right confluence of economic and geopolitical developments – we could see gold spike to $1500 or even $2000 in the next few years.

This is hardly an audacious forecast when looked at relative to the upward march in consumer price inflation over the past 28 years.  After all, the previous high of $875 an ounce in January 1980– after adjustment for inflation since then – is today equivalent to more than $2200.

History Lessons
The gold-price spike in 1980 reflected, in large measure, a fear-induced rush into gold prompted by the geopolitical events and economic developments late in the prior decade – in particular the Iranian hostage crisis, the Soviet Union’s invasion of Afghanistan, record oil prices, and sky-high price inflation.

As we begin 2008, fear is creeping back.  Fear of a wider war in the Middle East, fear of U.S. military intervention in Iran, fear of higher oil prices, fear that financial institutions are in bad shape following the mortgage-backed bond crisis, and fear of stagflation.  Moreover, as refreshing as a new U.S. President and Congress may be next year, some are concerned that they will pursue still more inflationary economic policies.

Gold is now appreciating not only against the U.S. dollar – but also in euros, sterling, yen, rupees, and other currencies.  In the past, currency synchronization has been a reliable indicator of forthcoming gold-price strength.

Bull Points Summarized

The price of gold reflects the interaction of sometimes complex and often interdependent developments.  As I see it, the key forces contributing to the metal’s strength now and in the year ahead are:

  • Fear of recession – Fed Chairman Ben Bernanke does not want to take the blame for a deeper slide into recession.  Neither does Congress or the Administration, especially in this election year.  So, it’s likely the Fed as well as fiscal policymakers will take more aggressive steps to minimize the economic downturn.  This means lower interest rates and continued rapid growth in money and credit.
  • Higher inflation later this year and into 2009 – The U.S. consumer price index rose at annual rate of 4.8 percent in January and now stands 4.3 percent over the year-ago level, near a 16-year inflation high.  Producer prices are rising even more rapidly with the index up 7.4 percent from last January.  Lower U.S. interest rates and continued rapid growth in liquidity promises still higher inflation in the next year or two.
  • U.S. dollar depreciation – Some analysts think the dollar’s decline is overdone.  But I think differently.  A weaker dollar is necessary to make America competitive in world markets and shrink the trade deficit.  In contrast to popular opinion, the dollar is not too weak – it is too strong as evidenced by the large and growing trade deficit now running at close to $700 billion a year.  While necessary to right the country’s trade imbalance, a cheaper dollar will add to inflationary pressures.
  • Uncertainties about the safety and solvency of banks and other financial institutions – and the disinclination of lenders to increase loan portfolios even as the Fed reduces interest rates and increases the availability of credit to the banking system.
  • High oil prices – Even if oil settles down a bit, the price effect of $90 to $100 oil has not worked its way through the economy and is not yet reflected in the cost of many other goods and services requiring oil and other energy inputs.  Uncertainties about supply (because of violence in Nigeria and other African producing countries, anti-U.S. politics in Venezuela, and instability in other oil-producing nations) may keep pressure on oil for some time to come with further big increases ahead.
  • The U.S. Presidential Election – and greater uncertainty about future U.S. policies with respect to Iraq, Iran, domestic affairs, and the economy.  Many expect a Democratic Administration and Congress will spend more and tax less.
  • Geopolitical tensions in the Middle East (Iran, Iraq, Pakistan, not to mention Israel and the Palestinians) and Russia increasingly flexing its own muscles.  Part of gold’s allure is its traditional role as a safe haven in troubled times – and this is certainly contributing to strong investor interest in the current environment.
  • An already tight supply/demand balance that promises to become even more supportive over the long term.
  • The availability of securitized gold in the form of bullion ETFs is making gold more accessible to more investors around the world.

The Banking Crisis, Monetary Policy, and Gold
The breakdown in borrowing and lending triggered by the mortgage crisis and the massive write-downs at major financial institutions has fueled interest in gold as a monetary asset and currency substitute.

To shore up the damaged financial sector, the U.S. Federal Reserve has lowered its target fed funds rate by 2.25 percentage points to its recent level of 3 percent. The Fed’s aggressive rate-cutting response to the credit squeeze and faltering economy is undermining the dollar – raising the risk of much higher price inflation at home and a weaker dollar abroad.

From recent public statements, it seems that the Fed is committed to push harder on the monetary accelerator as the road signs of recession flash and the stock market skids downhill.
Unfortunately, we are in a liquidity trap of sorts.  With banks and other lenders tightening standards for both households and business, while increasing their margins rather than lowering the cost of credit to their customers, the reduction in the Fed funds rate is not translating into the expected rise in bank lending.  Nor, has the Fed’s interest-rate policy calmed the equity markets.

By pumping money into the economic system Federal Reserve Chairman Ben Bernanke is risking a replay of the 1970s when easy money, high oil prices, rising inflation, stock market anxiety, and geopolitical tensions culminated in the gold-price spike of 1980.

In addition to undercutting the U.S. dollar and stoking the fires of future inflation, the Fed’s low interest-rate policy also lowers the opportunity cost of holding gold relative to interest-bearing assets like Treasury securities or money-market accounts.

Economic Indicators – Positive for Gold

“Recession” is loosely defined as two consecutive quarters of declining real gross domestic product but it is officially determined after the fact by the National Bureau of Economic Research based on the depth, duration, and diffusion of the downturn in business activity.
The U.S. economy is already in recession -- if not by official government statistics then surely by the pain felt by many American households!  Just look at the auto sector and drop in business activity in both manufacturing and the service sector, mortgage foreclosures, falling home prices and fewer housing starts, retail sales, rising unemployment and declining real incomes, and the mess in the financial sector.

At the same time, inflation indicators are already flashing bright red.  The consumer price index rose 4.1 percent in calendar 2007, the biggest annual increase in 17 years.  Most of us are well aware that our cost of living is going up more rapidly than indicated by the official data.  Look at the cost of groceries at the checkout counter, look at the price of gasoline at the pump, or your household utilities, even the cost of going to the movies.

The Fed’s low interest rate / easy money policies -- along with the fiscal stimulus coming this spring in the form of bank checks from the U.S. Treasury -- likely means higher inflation and a weaker dollar down the road.  And this bodes well for gold prices later this year and next.

In early January, Moody’s warned if the United States fails to rein in the cost of Social Security, Medicare, and Medicaid the nation’s credit rating will be downgraded within a decade.  Moody’s is telling America it needs a period of belt-tightening if not austerity – something that we are just unwilling to accept.

In fact, quite the opposite seems likely as aging baby boomers increase the costs of these programs and some form of government healthcare program is likely to be adopted.  And, many expect that a Democratic Administration and Congress will spend more and tax less – pushing the Federal budget even deeper into deficit.

Long-Term Fundamentals
It’s important to distinguish fabrication demand for gold from stock demand.  Fabrication demand is metal that is consumed in jewelry or by industry.  Stock demand – positive or, at times, negative – is the net change in official reserves and investment holdings.

Jewelry, which accounts for 70% of total gold consumption, is extremely price sensitive. With rising prices, consumers buy less . . . and more old jewelry comes back to the market in the form of scrap.

India is the biggest buyer of gold jewelry (558 tons last year) and China (331 tons), now the world’s largest mine producer, is close behind.  Both countries have a long tradition of hoarding gold, often in the form of high-karat jewelry, as a form of personal savings and hedge against inflation, currency debasement, and other risks, both economic and political.

Over time, we expect jewelry demand in India and China will continue rising, reflecting the growth of these two economies and the expansion of affluent middle classes.  This very positive long-term trend will be overwhelmed at times of rapidly rising prices by a drop in new jewelry purchases and increased scrap from old jewelry sold back will increase.  But as prices stabilize, even at higher levels, buyers will return and jewelry scrap will fall to normal levels.

On the supply side we have mine production and scrap (or secondary supply) recovered from jewelry sold back to the market and industrial recycling.

Mine production responds to new exploration and development activity with very long time lags.  So, today’s price-inspired rush to find and develop new mines is not likely to benefit actual supply until well into the next decade.  Meanwhile, the supply of new gold from mine production is likely to decline this year, reflecting:

  • Less mine exploration and development in the late 1990s and early years of this decade.
  • Rising costs and mine depletion are continuing to hit South African gold production, now at its lowest level in 80 years – and these trends will certainly persist for the next few years.
  • On top of this, electric power outages and shortages – which emerged this January and seem likely to continue for several years – are taking a heavy toll.  For example, AngloGold Ashanti, the world’s third-largest and South Africa’s biggest gold producer with production last year of 5.48 million ounces recently warned the power reductions could cost the company as much as 400,000 ounces this year.
  • The tendency for companies to mine lower-grade previously uneconomic deposits in order to extend mine life results in fewer ounces from the same quantity of ore mined and processed.
  • A cutback in mine exploration and development in the late-1990s and early years of this decade.  Although exploration and development has picked up in the past year and continues, it will still be a number of years until new production kicks in.

While gold mine output continues to decline in the “traditional” producing countries (South Africa, the United States, Australia, and Canada), the “new” big producers (China, Russia, and Peru) may see some small rise in mine production this year.

China’s gold production rose last year by 12 percent to 276 tons (9.7 million ounces) and may advance further this year – but the industry is not optimistic about future trends.  Without new mine development, at current rates of production, China will deplete most of its currently identified deposits by 2020, give or take a few years.  That’s unlikely to happen, given the rush of activity and the interest of foreign companies to explore and develop mines in that country – but it does suggest a number of lean years ahead.

The Russian Gold Industrialists Union expects domestic mine production to advance this year after five consecutive years of declining output.  At 163 tons (5.2 million ounces), Russia accounted for about 6.6 percent of world gold output last year, making it the fifth largest gold producing country in 2007.  By 2015, the Union forecasts production will rise to 225 tons (7.2 million ounces).

Gold Bullion Shares – A Boon for Investment Demand
Gold bullion shares, also known as gold-backed Exchange-Traded Funds (ETFs), are paper certificates that move with the metal’s price but avoids some of the taxes, storage issues, and other difficulties associated with owning physical gold.  Their growing popularity is giving gold a big boost by making bullion more accessible both to both individual and institutional investors.

The first gold-baked ETF began trading in Australia in March 2003.  Since then, similar funds backed 100% by bullion have been launched in England, South Africa, the United States, Singapore, Mexico, and India – and will soon be listed in Hong Kong and Tokyo, and may be followed by a Dubai listing too.

It was the listing of StreetTracks Gold Trust (GLD) on the New York Stock Exchange in November 2004, however, that underwrote the subsequent rapid growth in this gold-investment vehicle.  GLD is now the largest exchange-traded fund backed by bullion. Last year, StreetTracks Gold Trust also began trading on the Mexican and Singapore exchanges.

Importantly, gold ETFs are backed by actual gold bars, effectively removing metal from the market.  Each GLD share issued is matched by a tenth-ounce of actual gold bullion purchased in the market and deposited for safekeeping in an allocated account in the London vault of the fund custodian.  So, for example, an investor purchasing 1000 shares in this gold ETF is, in actuality, buying 100 ounces of bullion.

By early 2008, nearly 640 tons (over 20 million ounces) had been bought by investors in StreetTracks Gold Trust.  And, at least 220 tons more have been purchased by investors via gold ETFs traded on other stock exchanges around the world.  It’s hard to say if buyers of gold ETFs are long-term investors rather than short-term traders – but, for now, they are certainly a positive influence.

Official-Sector Transactions
The official sector (including central banks as well as the International Monetary Fund and the Bank for International Settlements) was not an active player in the gold market in the late 1970s and 1980s.  But in the 1990s, the official sector became a significant net seller of gold – and continues to be – with net official sales last year in the neighborhood of 500 tons. Though we can, at best, make an educated guess, it now looks like net official sales will decline this year.

Based on IMF statistics, it appears that sales by CBGA signatories totaled 517 tons during the first agreement year (September 27, 2005 to September, 26, 2006), then fell to 393 tons in the second agreement year, and rose to 477 tons in the third fiscal year ending this past September.  On a calendar-year basis, it looks like net official sector sales in 2007 were just under 500 tons, close to the average net central bank sales of the last decade.

Most of the sales last year came from the signatories of the Central Bank Gold Agreement.  The biggest seller was Switzerland followed by Spain and then France.  The Philippines was the largest seller outside the CBGA with sales of 15 to 20 tons.

We are now in the fourth year of the second Central Bank Gold Agreement, which limits central bank gold sales by the 17 signatories as a group to no more than 500 tons per fiscal year beginning the 27th of September.

It looks like official sales from the Eurozone might be off a bit this year.

The Swiss central bank was last year’s biggest seller at 145 tons – and they have begun 2008 with January sales near 12 tons, close to last year’s monthly average.  Although monthly sales may fluctuate, expect 2008 to be a repeat of last year.

France was the next biggest seller last year with total sales at 96.  France also has a steady selling program so we expect a repeat performance in 2008.

However, sales from the Netherlands have likely ended, Spain having run down its gold holdings by 135 tons last year now has less leeway to sell, and Germany, which sold only five tons last year has said not to expect any sales this year.

Additionally, some buying by smaller central banks wishing to further diversify their official reserves out of the dollar suggests that net official sector sales may not reach last year’s total.
Two big wildcards in the official sector are the IMF (bearish) and the Bank of China (bullish).

There is some risk of gold sales by the International Monetary Fund.  Finance ministers of the Group of Seven industrial countries recently recommended gold sales to cover the Fund’s operating expenses.  The U.S. Treasury has also endorsed the G7 proposal to sell 12.9 million ounces of IMF gold.

However, any IMF sales would require U.S. Congressional approval.  No legislation has yet been introduced nor is likely in this U.S. election year – and Congress blocked a similar proposal to sell IMF gold in 2005.

In any event, IMF gold sales won’t necessarily dent the metal’s price.  Between 1976 and 1980  -- a period of sharply rising gold prices -- the Fund sold 1,600 tons (56.4 million ounces), one-third of its gold holdings, yet gold still moved sharply higher during the period.

It is more likely that one or more nations with large and growing U.S. dollar official reserves – or sovereign wealth investment funds acting on behalf of governments – will seek to diversify into the euro, other currencies, or even a small portion directly into gold.  Any reserve diversification would be a blow to the dollar and a boon to gold.

China is, of course, at the top of the list.  Its official reserves are now close to US$1.5 trillion but its 600 tons of gold are a mere one percent of its total reserves.  Relative to other major nations, China’s official gold reserves, whether measured in tons or as a percentage of total reserves, are extremely low.  This compares with over 8,100 tons held by the United States (77% of total reserves), 3,400 tons held by Germany (66% of total reserves), 2,600 tons held by France (57%), 2,452 tons held by Italy (66%), 1,100 tons held by Switzerland (40%), 765 tons held by Japan (2%), and 622 tons held by the Netherlands (62%).

Pressure to diversify its foreign exchange holdings out of U.S. dollars could certainly result in some gold buying as well – and, now, with China producing about 260 tons annually it has some incentive to see gold prices move higher to benefit its domestic mining companies.

Central Bank Gold Agreement
In order to improve gold-market transparency, provide a greater sense of certainty from year to year, and minimize the impact of their activities on the metal’s price, 16 European central banks agreed publicly to coordinate and limit their aggregate gold sales to roughly 400 tons each year and no more than 2000 tons during the five-year period from September 27, 1999 to September 26, 2004.  In the event, the central bank signatories to the Central Bank Gold Agreement (CBGA-1) sold precisely 2000 tons during the five years.

Some six months prior to the expiration of the first Central Bank Gold Agreement, the European central banks signed a second Central Bank Gold Agreement (CBGA-2), this time limiting their annual sales to no more than 500 tons per year and no more than 2500 tons during the five-year term from September 27, 2005 through September 26, 2009.

The 16 signatories to the first Central Bank Gold Agreement were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Slovenia, Spain, Sweden, Switzerland, United Kingdom, and the European Central Bank.

CBGA-2 saw the UK drop out and Greece opt in.  Slovenia, which was not a member of the Eurozone until January 2007, signed on in December 2006 bringing the number of central bank participants to 17.

Gold Lending and Producer Hedging
A good case can be made that producer hedging and de-hedging – that is forward sales and the unwinding of those positions by mining companies – is itself a form of investment or speculative demand reflecting the sentiment of mining company executives and their expectations of future prices.

Just how is mine hedging connected to central bank lending?

In the simplest case, a mining company (MineCo) borrows bullion and sells it immediately at the current market price.  The major lenders of gold are central banks wishing to earn some small return on a portion of their gold reserves.  MineCo intends to repay the gold loan out of future production – and when it does so, gold is returned to the central bank lender.  Effectively, MineCo is receiving today’s price for gold that will be produced and delivered back to the lender sometime in the future.

In the past few years, as bullish sentiment spread, many mining company executives came to believe that they sold their future production too cheaply.  Hoping to benefit from anticipated higher prices on future production, some mines repurchased their own forward sales or held back their current production in order to repay their gold loans early.

What’s the impact on the gold market and price?  Hedging – that is selling future production today – increases the quantity of metal currently available in the market.  Gold lent by central banks is gold sold by miners.  Mining companies de-hedge by repaying gold loans out of current production – or, if current production is insufficient, miners will purchase spot gold in the market.  In either case, de-hedging diminishes the supply of gold available in the market.

Producer de-hedging probably took some 13 million to 15 million ounces off the market in calendar 2007 as mining companies repurchased prior forward sales and returned gold to their lenders.  De-hedging is likely to be somewhat less supportive this year, if only because the mining industry’s total outstanding forward sales have already been cut back to no more than 30 percent of their peak level.

A number of large mining companies have announced their intention to repurchase prior forward sales.  Adding up the remaining outstanding hedge positions of the larger mining companies at the end of last year suggests this year’s reduction in market supply may be on the order of five-to-ten million ounces.